Definition
Deferred revenue, also known as unearned revenue, is money received by a company for goods or services that haven’t been provided yet. Essentially, it’s a liability on a company’s balance sheet that represents an obligation to deliver products or services in the future. The revenue is recognized only after the company fulfills its contractual obligations.
Key Takeaways
- Deferred Revenue, also known as Unearned Revenue, refers to payments received by a company for goods or services that haven’t been provided yet. It implies that the company has a responsibility to deliver the promised goods or services in the future.
- This term is considered a liability on a company’s balance sheet because it represents a payment received for a commitment that the company has yet to fulfill. Failure to deliver on this commitment can result in refunding the payment to the customer.
- As the company delivers goods or performs services, the deferred revenue becomes earned revenue. Then, it moves from the liability section of the balance sheet to the revenue section of the income statement.
Importance
Deferred revenue, also known as unearned revenue, is a crucial concept in finance because it represents payment received by a company for goods or services that have not yet been delivered or completed.
This is important as it directly impacts a company’s financial health and operating cash flow.
It also keeps a company’s accounting transparent and accurate in line with the revenue recognition principle, which states that revenue should only be registered once the service has been provided or the product has been delivered.
Without accounting for unearned revenue correctly, company revenues may be overstated in the short term, which can result in misinterpreted financial statements and undermine accurate financial planning and decision-making.
Explanation
Deferred revenue, also known as unearned revenue, serves a vital purpose in accurate financial reporting by ensuring that earned and received income are appropriately matched. This is integral to the accrual accounting method, which aims to record revenues and expenses as they are earned and incurred, regardless of when cash transactions occur. Deferred revenue plays an essential function in this approach by recognizing that even though a company has received payment for goods or services, it may not have fully earned that income if they have not yet been completely delivered.
This can apply to a variety of scenarios, like a magazine subscription or multi-year service contracts. The purpose of deferred revenue is to accurately represent a company’s obligations towards its clients. By documenting received income that is yet to be earned as a liability rather than revenue, businesses can demonstrate their commitment to deliver the goods or services that have been paid for in advance.
This enhances transparency and financial trustworthiness. On financial statements, this appears under current liabilities if it is expected to be earned within a year and as non-current liability if it spans a longer time frame. It decreases over time as the company fulfils its obligation by delivering the prepaid goods or services, adjusting the balance from liabilities to revenues.
Examples of Deferred Revenue (Unearned Revenue)
Subscription Models: Many companies like Netflix, Disney+ or any monthly magazine subscription service follow a subscription-based model where customers pay upfront for a specific period, say, one month, six months or a year. These payments are recorded as deferred revenue initially and considered as revenue only when the service is rendered month-after-month.
Advance Rent Payment: If a tenant pays rent in advance, such as a for a year, it is considered as deferred revenue for the landlord. The landlord can only recognize this as revenue on a monthly basis because the rental service is provided over time.
Airline Tickets: When customers purchase airline tickets in advance, the airline cannot recognize the entire amount as revenue until after the flight takes place and the service is provided fully. Thus, until the flight is taken, the money collected is considered deferred revenue.
FAQs for Deferred Revenue (Unearned Revenue)
What is Deferred Revenue?
Deferred Revenue, also known as Unearned Revenue, is money received by a company in advance of having earned it. In other words, it’s a prepayment for goods or services which are to be delivered in the future.
Is Deferred Revenue an asset or a liability?
Deferred Revenue is considered a liability because it represents an amount that is owed to a customer. Once the product or service is delivered, it’s recorded as revenue.
How is Deferred Revenue treated on the balance sheet?
On a company’s balance sheet, Deferred Revenue is included in the current liabilities section. It’s recognized as income over time as the goods or services are provided to the customer.
Where do we classify Deferred Revenue in the cash flow statement?
In the statement of cash flows, Deferred Revenue is included in the operations section because it corresponds to the cash transactions with the customers.
What is an example of Deferred Revenue?
An example of Deferred Revenue could be a subscription to a magazine. If someone pays for a year’s subscription, that money will be recognized as Deferred Revenue until the magazine issues are delivered to the customer each month.
Related Entrepreneurship Terms
- Revenue Recognition: The concept in accounting that determines the specific conditions under which revenue is recognized within the financial statements.
- Prepayment: A payment made in advance for goods or services that will be received in the future.
- Accrual Accounting: An accounting method that measures the economic events of a business by matching revenues to expenses at the time in which the transaction occurs, regardless of when the payment is actually received or made.
- Liability: A financial obligation, debt, or responsibility that an entity incurs during business operations.
- Deferred Income Tax: A liability recorded in the balance sheet resulting from a difference in income recognition between tax laws and the company’s accounting methods.
Sources for More Information
- Investopedia: An extensive finance and business resource that offers definitions for finance terms including deferred revenue.
- Accounting Tools: A site dedicated to accounting concepts that provides clear explanations of finance terminology.
- Corporate Finance Institute: A professional training and certification provider in financial analysis and modeling which includes educational resources about various finance topics.
- Accounting Coach: Offers free and comprehensive accounting course and resource materials, which includes definitions of accounting and finance terms such as deferred revenue.
